Aaron Brown: The Poker Wizard of Wall Street

Aaron Brown has been involved in finance and speculation for decades – since his college days as a trader and poker player to his current “day job” with the hedge fund AQR Capital Management. In between he was head of mortgage securities for a New York investment bank, a teacher of finance at Fordham and Yeshiva Universities, and a risk management professional at a Who’s Who of Wall Street firms including JP Morgan, Citigroup and, most recently, Morgan Stanley.

He is the author of The Poker Face of Wall Street,
a book that is part autobiography, part critique of contemporary finance, and part exploration into the world of professional poker, where many of Aaron Brown’s ideas about life, creativity, risk and ambition seem to merge. In a brief explanation of what led him to write the book, Brown reflects: “I wanted (the reader) to take my ideas as an integrated whole, not a series of contentions to be evaluated one at a time. I don’t expect anyone to accept everything in the book, but I hope everyone who reads it looks at finance, risk and poker a little differently afterwards.”

We spoke with Aaron Brown by telephone on Monday, June 9th. What follows are both parts of our two-part conversation. In the firs part, we focused on his ideas about speculation and gambling – from poker to blackjack to sports wagering to, of course, trading. We also talked about some of the trading techniques he practiced as a young – or at least younger – independent trader in the years before he became a trading professional.

In the second half of our interview with Mr. Brown, we took a closer look at the world of hedge funds – from what Aaron Brown’s own life at AQR Capital Management is like to the broader topic of how hedge funds and banks have learned different lessons from the crises that have struck both industries over the past decade. Suggesting that hedge funds have done a better job of learning from their mistakes than many Wall Street investment banks seem ready to do, Brown looks at the future of both industries and suggests what changes he thinks may come about in the wake of the current financial challenges.

David Penn: I thought the subject of poker might be a good place to start, since you are just back from the World Series of Poker. For those who are a little less familiar with the poker world, is the World Series of Poker one of these tournaments that have become more and more popular over the past five or ten years?

Aaron Brown: Yes. It is the big one, and mostly because it’s the oldest. For years it was the only poker tournament. It’s now in its 39th year of running. It started as a casino publicity stunt with seven Texas players, just to bring some tourists into the casino, but for one reason or another it kind of became a gathering place for the poker community. I don’t like tournaments, myself, and I don’t like casinos, so I’ve never played in a WSOP, but I go every year in June before it gets too crazy. The tournament runs from early June to mid-July, and this year they’re actually extending it to November for the final table.

Penn: Impressive.

Brown: But in the early part, in June, the events are normal and the crowds aren’t too big. It’s sort of like an annual convention for poker players. So you can just catch up with everybody you’ve lost track of over the year.

Penn: Sure. Did you get any poker playing yourself?

Brown: Sure. I like the cash games. The World Series is a very good cash game time to play: Other people, like me, come hang out at the tournament, in addition to people who busted out of tournaments or people who are waiting for their tournament to start. So you get some very good cash game action in the early part of the tournament.

Penn: For how many years have you been going to these events?

Brown: My first one was in the late 1970s, and I would guess I’ve got 20 of them over the years. I pretty much go every year, now. Other times in my life I couldn’t get away, sometimes.

Penn: What do you think is behind this phenomenon of poker over the past years? Not just in terms of people participating, but even watching tournaments on TV. What do you think’s going on with this real interest that’s developed?

Brown: There’s no doubt about it: It’s the Internet.

Penn: Really? Online poker?

Brown: To be a serious poker player, you really have to start young. You have to take it very seriously. And unless you happen to grow up in a place where poker was taken pretty seriously, you had no real chance of becoming a serious poker player. You might learn the game later, you might enjoy it, but it was never going to be that important for you. And that basically meant the American West.

Penn: Interesting.

Brown: Maybe there were 10-20 million people who conceivably could have become poker players. Now, anywhere in the world you’ve got an internet connection, you can get online and you can play with the top players in the world. It’s just an explosion in the number of people who can play, an explosion in the quality of play as well. These kids who practice on the internet play more hands when they were 14 than traditional poker experts played their whole lives. And they’re incredibly good. Right now you’re not seeing them dominate the tournaments just because they haven’t picked up quite enough face-to-face experience, but in the next three or four years, that will happen.

And you won’t find anybody my age even in the competition any more.

Penn: I was watching an event last night. And the guy who ended up winning was a 23-year-old kid. And I’ve seen a couple of these young folks doing well. What sort of edge do these young kids have?

Brown: Well, they have tremendous experience. As I say, they’ve played a tremendous number of hands, which is very useful. Focus, energy, pliable brain, there’s a lot of stamina involved in winning a poker tournament as well. Experience helps some, but eventually talent and practice win out. Another huge advantage they have is they learned it right from the beginning. When I was growing up there were no good poker theory books. All the poker books were written by bridge players, and there was really nobody to learn from until you progressed enough in the game to meet some top players.

Penn: But now …

Brown: Now, anybody can sit down and read a book or check out some internet sites and get world-class advice. So that’s a huge leg up. You don’t have to spend years re-inventing things people already know.

Penn: There have been a lot of people who have talked about comparisons between blackjack, poker, sports wagering, trading – all these different sorts of speculative activities. And I was reading an interview where you talked about blackjack. You noted that you’re not really playing with psychology or anything like that. Instead, you’re trying to find the smallest playable edge, and then just working it over and over. In poker you have statistics involved, mathematical edges, but there’s such a huge psychological aspect to poker as you well know. How analogous is the significance of that psychological edge in poker to the sort of psychology that people deal with when they’re trading?

Brown: Yeah, it is very important. You know, all three of the games you mentioned are analogous to aspects of trading. With blackjack, once you’ve built a strategy and you’re milking it, you’ve just got to run it efficiently and be patient and make sure you plan for the downswings. Sports wagering is very much like finding a new edge in trading. For example, you’re saying, “OK, what am I going to invest in, how am I going to do it, what strategy am I going to find?” Very much like a sports wager guy who looks around and says, “What sport am I going bet on, what kind of bet in that sport, and how am I going to do better than the spread?”

Penn: Sure.

Brown: Poker is more like choosing trading as a lifestyle. That is, somebody decides, “OK, I’m going to commit a significant portion of my life and a significant portion of my financial assets to trading as an activity.” That is very much like playing poker.

If you want to make a living at blackjack, it’s kind of a nine-to-five job. There are certainly traders who do that; a lot of quant traders are like that. First, they’re going to find their edge, then they’re going to exploit it, and they’re just going to milk it and milk it until it goes away. Or maybe it never does and they just milk it. But once the system is running, it’s not very exciting. With sports betting, you have excitement every trade. However good and careful you are, you’re always looking for that extra piece of information, that extra thing to get in or out a little earlier or a little later. And poker is a very different kind of thing. Neither blackjack nor sports betting is credit-important. But poker, credit is very, very important. But poker players always lend and borrow from each other.

Penn: It’s much more social.

Brown: Poker really plugs you into a network, which is not true of anything else. Poker is kind of like saying, “I’m going to move to New York, I’m going to meet a lot of traders, and I’m going to maybe work for a hedge fund or an investment bank or maybe be on my own, but I’ll make sure I’m connected with these people so I know what’s going on.” It is much more of a social network kind of thing, a much easier way to make money. Some traders have picked trading because they like to sit alone in a room and not hang out with people very much, and just make their money on their own. They don’t even want to work for a small hedge fund. It’s a lot harder that way. You can do it, but it’s a lot more fun, a lot easier, if you’re in a network of people.

Penn: If I understand it right, you got involved in poker more heavily, more seriously, around the time you were at Harvard. Were you a natural when you started picking up poker?

Brown: To be good at poker, you need two things. To be a natural at poker, you need a certain mathematical card sense – whatever you want to call it. That is, the same thing that might make you a good bridge player, a good chess player, or something. And you also need to be very, very attuned to other people and very introspective. You have to know yourself very well, you have to read people very well. And that typically goes along with shy people. So you’re going to be a shy math nerd. And the problem is, for most of these shy math nerds, they’re not going to walk into a basement full of tough looking men and play an illegal game and expect to walk out of there with their money.

Penn: Sure.

Brown: That’s not naturally what you’re going to do. And I had to force myself to do it – it was extremely hard. I couldn’t go up to a girl and ask a girl to a dance, and I wasn’t going to go into a basement pool room where somebody told me there was a poker game going on, and do it. But I forced myself, because it did mean so much to me.

I sort of overcame that, I overcame that shyness. I overcame that risk aversion. And I believe that the things that take you far in life, are not so much your strengths, but the weaknesses that you overcome. And that was very important to me. I don’t think I ever would have had the guts to trade, I never would have had the courage to walk out on the options floor and start trading options and really bet money on things, without anyone telling me how to do it, without a big organization. If I hadn’t as a teenager, 14-15, walked into some of these basements and then, in Boston, gone to play poker games with all kinds of people all over, I wouldn’t have become the person I am now.

Penn: Would you say that the best way to start in poker is pretty much the same way you would encourage someone to start trading: you start small, with fairly uncomplicated games or strategies, and slowly work your way up as you become more successful?

Brown: I’m going to get in a lot of trouble for this. I don’t know that that’s really right.

I mean, it’s probably right in a theoretical sense, right. It would be nice if everyone were sensible and did it that way. But if you really have the poker gene or you have the trading gene, if you’re really going to be good at this, you just don’t have the patience for that. You’re going to jump in and play. And the key thing, when I interview somebody for a trading position or anything that involves a risk, I look for someone who sits around and watches people play for a bit and then wants to try it. This person knows that he’s at a disadvantage, knows that he hasn’t read any books on the thing, knows that he hasn’t studied it for years. But he looks at it, and he can kind of figure it out as he goes along.

If you don’t have that ability, if you’re really the kind of person who wants to read three books and get a degree and have somebody tell you how to do it, and practice for a long time, that’s all very sensible and it should be good to do. But if you really can do that, you’re probably not the kind of person who’s going to be good at this. I’ve got a lot of sympathy for people who get into either poker or trading and make some mistakes and go broke a few times. The most common denominator amongst really successful people is they’ve gone broke a lot of times, and they’ve failed a lot of times.

Penn: Interesting.

Brown: And there’s just a certain kind of person who is willing to do that. I explain it in option theory terms. Some people really feel like, “My life is an option and I maximize that option value by increasing its volatility. I either want to hit it big and really find something I’m good at that I love that’s a big success, or I want to go broke and then I’ll go off and try something else.” And if that’s really your attitude toward life, I think you’re set up to be successful at trading or poker. And if it’s not your attitude, then you might find the two activities very dangerous. You might learn how to do them, you might study very carefully, you might be a prudent person, but I don’t know if these trading or poker will really make you happy, even if you get good at them.

Penn: At the time when you at college, were you thinking about a Wall Street, a finance-type of career, or a trading type of career?

Brown: I’ve been trading for some time. The book that really got me into it was Ed Thorp’s Beat the Market:.
He was the mathematics professor who wrote, Beat the Dealer on blackjack card counting. Sheen Kassouf was the co-author on Beat the Market. In college I thought of poker, trading, and games like bridge, backgammon and gin rummy, all in the same terms, things you could do to make a living and have some fun, while you did whatever else you wanted. I never thought about getting a job.

But I think I wanted a little respectability. I was smart, it was not hard for me to get into the academic program, and it wasn’t hard to do the work. And it gave me something to do during the day, to tell people. You don’t want to say, “I sit around my room and I trade,” right. You say, “Well, I’m going for a Ph.D. in finance, which is why I’m sitting in my underwear talking to a broker.” It sounds infinitely more respectable. So I went into the University of Chicago finance PhD program.

Penn: Sure.

Brown: And then I didn’t know how it was going to work out. Would I want to teach, did I want to go to work for a big firm, did I want to trade by myself, but have the letters after my name? It wasn’t a big sacrifice. I enjoyed it, they paid my way in grad school, and they gave me a stipend. And it just seemed like a comfortable way to do what I wanted to do anyway.

Penn: Did you come from any family that was involved in finance or trading or anything like that, or were you the only one to strike out in that direction?

Brown: My dad was a Communist, although I think he’s changed his beliefs perhaps a little. Any money you didn’t work for – and he had a fairly strict definition of what “working for it” meant – was just immoral and wrong. And if you made money off of other people’s work, if you speculated or anything like that – that was wrong to him. But he was a scientist, and he really encouraged us to go where curiosity took us. Maybe that’s the real explanation for the Ph.D., that it made it okay in my dad’s eyes. You can do anything you want as long as it’s an experiment, as long as you’re advancing science.

Penn: Sure.

Brown: But the idea of just going out and trying to make money was immoral, he believed, whether that would have been poker or finance. In fact, poker was probably somewhat more respectable than doing it on Wall Street. None of my brothers had any interest. They were all engineers of one sort or another, or professors. They all took that sort of route. It just never had the slightest appeal for me, you know.

Penn: When you were trading for yourself were you very short-term oriented in terms of your trading? What kind of trading were you doing?

Brown: The thing I was best at, that was really the one thing I might have stayed trading in as a full time job, was options. And it was very short-term, very opportunistic. You’d look for mispricings. I would put out positions where I had very specific, very closely hedged positions. With very specific in-and-out points, and often these things would last less than a day. Maybe a week would be a long position for me, a long time to hold a position. But at other times I’ve traded bonds and mortgages, and I traded some stocks. Bonds was the only other area where I would say I really had worked to the point where I had a trading system that I think I could have made some money on, but it was just too boring to. The market was kind of illiquid and I was very frustrated at the inability to execute things. You see a price on a screen, and you couldn’t get it. Stuff would disappear, and you’d get one-half your trade and you couldn’t get the other. Options were great. They were so liquid and the stock market was so liquid you could do what you want.

Penn: Sure.

Brown: I never did my statistical arbitrage with stocks. I was sort of intrigued by it but never did much of that.

Penn: Could you give us an idea of the type of options trade you would have been making in those days?

Brown: Oh, sure. Now this is back in the late 70s, early 80s. And our market wasn’t quite as efficient as it was, but you still see these kinds of trades.

Penn: Sure.

Brown: Let’s say you’ve got a stock. And you’ve got two options at different strikes in the same expiry. The stock is lower than the midway point of the two exercise prices, but the difference in call prices is more than half the difference in strikes. So you’d buy the high strike call and sell the low strike call, then short a little stock for a delta hedge. Basically I would look for situations where I could put two options against each other, do a delta hedge on it with a stock, and just a fixed delta hedge. I didn’t do any daily rebalancing or anything. And I was at a profit for a wide range of stock prices. The profit range was far wider than I would expect the stock to move in a month. Any price up to $10.00 either way, I make money on this position. And there are a lot of those trades available.

I’d hold them, and if the stock started moving, say, five points, so I’m in some danger that maybe I might not make money, I’d liquidate at that point, take a small loss. And most of the time, either the proper relationships reasserted themselves and I could get out at a profit, or I just held onto it. Then you know at some point before expiry, the prices have to converge. And it was just very profitable to do that. This is before the days of computerized trading, and so just being able to calculate the stuff in your head was enough to make quite a bit of money.

Penn: Sure.

Brown: Now, of course, people have computers searching through for opportunities like that, and you’ve got to have a much better execution capability to do that sort of thing. But things haven’t changed that much. You still look for opportunities like that where you just make money. Anyway, I’ve never been a directional trader. I’ve always been a guy looking for arbitrage, looking for an edge, looking for something where I’m 90% sure this is going to make a little bit of money and I’m also 99.9% sure that I can stop it from losing a lot of money. And those are the kind of trades I lived on.

Penn: Right, right.

Brown: It’s actually quite easy to make money. People think it’s really hard. I don’t think it is. I think there are lots of great ideas out there, a lot of them are published and have worked for years and years, and show no sign of going away. And it’s easy to find your own. The problem is surviving long enough. None of these things have Sharpe ratios of 20 where you’re guaranteed to make money every year. So, you really have to be patient with them, and either have a lot of them, like we do, so you just kind of diversify, or really, really follow it very closely so you know when to get in and when to get out. The trick is to survive long enough for your edge to matter. If you’ve got a 2% edge a year, that’s great, you can get rich on that, but you’ve got to survive for 10-15 years to make that, and then the compound interest just makes you rich. But it does you no good at all if you go broke in the 12th year. You’ve wasted 12 years and you’ve got nothing to show for it.

Penn: Right.

Brown: So, you want to survive. And there is another part to that, and that’s particularly relevant now. When you want to take as much risk as possible without risking survival. That’s kind of hard for people sometimes. Especially after a loss or something, they’re too risk-averse. You do have to take risks when it’s in your favor. If you’re not willing to do that, then you’re going to either fail, or you’re going to end up taking risks at less favorable terms later on. So, I really believe that risk management, proper sizing, whatever you want to call it, making your bets the right sizes, is the fundamental key to success. Some people make better bets than others. Some people are smarter, and come up with better edges, or work more carefully, or something like that.

Penn: Right.

Brown: You’re much better off having that part figured out right, than to have a little bit extra edge on your trades.


More information about Aaron Brown and his book, The Poker Face of Wall Street, can be found on his website at www.eraider.com

DavidPenn: Can you describe what a typical day at your fund would be like for you?

Aaron Brown: I can’t talk about my fund, but I can talk about what a risk manager does. People have opposing stereotypes of financial risk managers. One is huge groups of people with accounting or legal backgrounds producing risk reports for financial statements and regulators. That’s back office risk management. Most people who work in financial risk management do this.

Another stereotype is one of the older traders mentoring the younger ones, telling them when to stop losses, when to let profits run, helping them size trades. This is front office risk management. Sometimes it’s done by the head trader, sometimes by another trader, sometimes by a former trader.

In the late 1980s, we had investment banks buying trading operations, and senior management found that the back office reports were uninformative, and the front office risk managers weren’t independent of the traders. So middle office risk management was born. I’m a middle office risk manager. We do the same sorts of things as front office risk managers, but in a more systematic and quantitative way. We hedge those exposures like counterparty risk and some kinds of market risk that can’t be hedged desk by desk. We aggregate risk across different businesses. Middle office managers are usually former quant traders, who want to continue trading, but also want to concentrate on the risk side of the risk/return tradeoff.

Of course, at a hedge fund, everyone pitches in and does what needs to be done, you don’t have the kind of formal separations like a big investment bank. So I do what front office and back office risk management needs to be done, and help out in other areas. Other people help me with the risk management.

Penn: Interesting.

Let’s look at what’s particularly roiling the markets right now. The credit crunch. The bad loans. What happened from your perspective? I think a lot of people are thinking: “Well, these are supposed to be the smartest guys in the world out there doing this kind of thing, what happened? Are they not so smart? Or did they just make the kind of mistake that all smart people are going to make sooner or later?”

Brown: The real answer is unpopular. is The reason smart people make mistakes is that it’s hard to get it right. Other fields have far more mistakes, but nobody admits them. You can be in politics your whole life, advance positions that are totally wrong, make no sense, and nobody ever notices. You can be in a business that over 50 years generates zero shareholder equity, but everybody involved in that business feels proud, feels like they went in and gave it a good day’s work. I like finance because it’s honest. Because you’re right or you’re wrong, and when you’re wrong you’ve got to correct it. But there few other fields like that-I think science is one of them.

I have no patience for fields where people argue about who was right 40 years ago. I want a field where if you’re wrong, you go broke, you get out of there, and somebody else takes your place. And if you survive and you prosper, you know in some sense you have to be doing something right. It’s not theoretical. It’s not somebody’s opinion.

Penn: Yes.

Brown: If other fields were run as honestly as finance, we would see far, far bigger mistakes. And far bigger meltdowns and problems. But we’d fix them and be smarter instead of living forever with the problems, and the arguments about whose fault the problems are.

Penn: That’s good. I think in the broader media that people hear of a financial problem, they think of Enron, they think of these things. But these are instances where companies go out of business and they’re done, CEOs get canned, and it’s over, as opposed to these other situations you mention where people can continue on making mistake after mistake, get reelected, get reappointed. There is a certain level of cruel accountability in this business when it finally catches up with people.

Brown: The example I like to give to people is this: Think of all the good that’s been done by all the wars in history, and think of how much effort and money has
been spent on that. And that’s a disaster. Net, nothing was accomplished. That’s where people get really stupid, and I don’t care whether you’re on the right or the wrong side. All it means is it was stupid, a lot of people got killed, a lot of people got destroyed for no reason at all.

And I think you’d say the same about an awful lot of politics and an awful lot of law, and a lot of business. And when you really look at it, these are not products that make people happy-they get in the way of human happiness.

If all these people were forced to own up to their mistakes the same way finance people are, it’d be a better world. Why do doctors make more mistakes than airplane pilots? Because doctors survive their mistakes. If you make a mistake as a pilot, you crash, you’re dead, it’s obvious, and everybody says, “Air travel is so unsafe.” But in fact, it’s remarkably, incredibly safe. Car companies fought seat belts and other basic safety equipment for years, so we still have 1.2 million deaths a year from cars, and 50 million injuries. 2% of all people are killed by cars but it’s airplane crashes that make headlines.

Penn: Right.

Brown: Finance is run much better than lots of other professions where you walk away from your mistakes. Nobody dies in finance, but if you make a mistake, you’re broke, and you can’t trade any more.

Penn: Focusing on the current financial crisis. I’m curious what you thought those mistakes were, and how much were those mistakes simply a matter of the size of the bets involved.

Brown: We’ve got a couple of levels of mistakes. One of them was everybody piling in the bet that real estate never goes down. That seems stupid in retrospect, but that kind of behavior is just chronic in financial markets. If something goes a certain way for a while, eventually people start betting too much that it will continue to go that way.

Penn: Sure.

Brown: And I don’t think there’s anything you can really do about it, that it’s just going to happen. There’s a lot more damage done in the world by people refusing to acknowledge trends than by people overestimating how long trends will continue. Momentum investors get us to the destination quicker, even if they cause some pain by overshooting.

There also is a lot of corruption. There was corruption in the lending practices, and with some of the securities put together and so forth. When you can make a lot of money there’s going to be a lot of people who are willing to lower standards or people who don’t even realize there are standards. They just figure they’re making money, so it must be right. That’s a human problem, and it’s always going to happen. At least in finance it gets exposed and fixed, it doesn’t fester forever blocking progress.

The next question is why subprime lending problems triggered a general deleveraging of the economy. I’d put that down mostly to a huge cycle of extraordinarily low credit risk prices, where you got paid nothing to take a huge amount of credit risk. One of the crazy things about this one is when you look back and people say, “They were blinded by greed, that’s why they did all these things.” But in fact, they were getting paid almost nothing for it, and taking tremendous amounts of risk. I think some of that is just institutional inertia. You didn’t see a lot of hedge fund failures-mostly, the real pain has been in the banks and mortgage companies.

Corporations feel they have to make more money than last year, you know. And so what happens is the spread gets cut in half, then they’ve got to double the business just to stay even.

Penn: Right.

Brown: And it never occurs to them to think that if the spread is cut in half, maybe it’s no longer good business. “Maybe I should get out and find somewhere I can get a good spread.” They don’t think like traders.

It’s hard to tell the management committee, “I want a smaller department next year,” hard to say, “We’re not going to meet the numbers from last year.” You look like a failure saying “We’re not even going to try to make the numbers for last year, the spread’s gone, it’s not worth the risk.”

So I think there is a certain amount of that, and that’s just something that good risk management has to fight. I worked in risk management in a number of these
places, and I know we were fighting that battle every day: Always going to people and saying, “Are you really getting paid enough for this?” “Why do you want to double your revenue from last year?” It’s a heretical question in a lot of places, but you say, “Why do you want to do it, what’s our risk/reward, what’s our Sharpe ratio on this?”

Also banks levered themselves. People talk about hedge funds being levered five times or three times or something. But the banks are all levered 30-50 times.

Penn: Wow.

Brown: And banks have riskier, less-liquid balance sheets than any hedge fund would ever hold.

So you’ve got two choices to reduce the problem next time, and I think either one of them could be a good choice. One is you say fine, let banks do grow and lever without restriction, and let them fail. The other is to say, “Gee, if the government’s going to come in and bail these people out, then it has to insist on much lower leverage ratios, much more equity capital.” And the crazy thing is that all these banks should have been raising tons of capital last year. In early 2007 when the problems became obvious, bank stock prices were high, their business models were good, they could clearly see they needed, or they might need, this capital. You don’t wait until you’re sinking to check around to see if your lifeboats are in good order.

Suddenly this year they’re coming out, after their stock is half the price from last year, and now they’re really hosing their shareholders by having to raise capital at this price.

And it might not be enough. We saw Bear Stearns go. Lehman looks like it is OK, but you never know. And Merrill and Morgan Stanley-people are worried about them. Commercial banks too, Citi for example. Some big foreign banks are even shakier, and you get less information about them.

There was a tremendous emphasis on return-on-equity. Tremendous focus on that, and really, if these things are too big to fail, if these things are going to bring down the economy, then they have to start focusing on return on assets, instead, and have to start focusing on leverage ratios. This is exactly the same thing hedge funds learned. Hedge funds, though, had no protectors. We had no choice.

Penn: Truly.

Brown: So we had to learn the lesson. If you don’t do these things in a hedge fund, you go out of business. The investment banks have reputational counterweight to some of the stuff, and they have some governmental assistance and so on, so maybe they can avoid learning it.

And I’m afraid that’s exactly what’s going to happen. I’m afraid they’re going to skate through this. They’re going to sit and they’re going to say, “Aha, great, we did it right. We didn’t raise any more capital than we had to and we survived, and now we can go take more risks and we can make back all that money we lost.” And that would not be a good outcome.

Penn: I just want to make sure I heard something you said correctly. You said that there was a big emphasis on return on equity instead of an emphasis on return of assets, which would have been more helpful?

Brown: Return on assets, right. If an investment bank is run entirely for shareholders, return on equity is fine. But then you’ve got to let it fail. If a bank is run for all its stakeholders, then it’s got to look at return on assets, because it’s got to get enough return on those assets to pay its debt, to meet its commitments to counterparties and other customers, to meet its regulatory obligations.

If you double your assets without raising equity, and you increase your profits by 10%, that’s great for your return on equity, right? You’ve got 10% extra return on equity and that’s a great thing. But it’s terrible for your return on assets. Now a small decline in the value of the assets can wipe out your equity, and put creditors and society at risk.

Penn: Right. Right.

Brown: And you just never hear about return on assets. I mean, shareholders don’t care, shareholders only want to see return on equity. That’s only fine for businesses able to fail.

Penn: You’ve mentioned the idea that a lot of the hedge funds have sort of learned this lesson. Would you say that was the lesson of ’98 or another point in time
where hedge funds really said, “Look, we’ve got to take care of ourselves, nobody’s looking after us.”

Brown: Yeah, I think that was a big lesson of ’98, but it’s been reinforced a few times since. People get big and we found out for example, it was kind of shocking to me, how quickly the Carlisle fund was blown up by its creditors.

Penn: Yes.

Brown: You know, here’s a company: they have equity capital, public equity capital, they didn’t have to worry about redemptions, they had a great reputation, they were a well-known, long-standing firm. You would have thought people would say, “OK, this is a big firm, we’ll give them an extra day or two.” But it meant nothing. And they were holding only government agency mortgages. It wasn’t like they were holding any weird, illiquid stuff or stuff that might default. None of that meant anything.

The minute anybody thinks a hedge fund might be in trouble, it can be gone the next day. You learn that, and you start doing real risk management. Banks, I’m
afraid, have had some near brushes with problems and they survived, and sometimes they have learned the lesson that you don’t have to be that careful about risk.

Penn: Very interesting. One thing I’m curious about is the process of re-establishing a sense of wanting to take risk again. Do you have to have massive failures?
Can you do this sort of thing where people are bailed out and still manage to get that renewed risk taking come back in any healthy sense?

Brown: It’s an interesting question. People always worry about the risk that caused the last disaster. Generals are always ready to fight the last war. That ends up increasing risk. People say, for example, “I don’t want credit, I don’t want real estate exposure.” So they’re going to run out and they’re going to say, “Gee,
commodities are really good, right, commodities maintain their value. In fact, they soared in value in this crisis, so I’m going to buy a lot of timberland, I’m going to buy a lot of oil reserves, I’m going to buy a lot of gold mining stocks, and things like that.” And who knows, that could be the thing that goes next, it could be we have a commodity crash and people find they’re over-exposed to that, because they’re underexposed to credit and real estate.

Penn: Yes.

Brown: These kinds of financial disruptions happen fairly regularly. Starting now, you get tremendous opportunities. It’s a great time to be a trader. It’s hard to get capital because no one wants to take risks, but you can get much bigger spreads off things for taking risks, because nobody wants to do it. Especially the kind of risk that just blew up.

Penn: Sure.

Brown: There are all kinds of things that got hurt that shouldn’t have gotten hurt, and we’ll sort it out. So it dramatically increases the profit potential. Then you see some funds and some traders, whatever, and they’re going to have phenomenal returns for the next two or three years, and people are going to start saying, “They must be geniuses, they figured it out, they survived the last crash, now they’re making so much money.” More and more money’s going to get directed to that. They’re going to have to chase thinner and thinner spreads, and you know-four or five years we’ll be doing this again.

Penn: What are some of the things that you think the average retail trader can specifically benefit from, by understanding more how trading is done in hedge funds? Or is it too dissimilar?

Brown: You know, I don’t think it’s dissimilar. The same basic things apply: you’re looking for alpha, you’re looking for ways to make an edge. You have to control your risk so you can survive the bad times.

I think there’s a gradual increase in scale from a retail guy who spends an hour a week playing around with a few thousand dollars, up to the biggest hedge fund in the world that is playing around with hundreds of billions. As you get bigger, you have to start worrying more and more about capacity, about market impact. But on the other hand, a lot of fixed trading costs go down.

There’s a sweet spot for every kind of trading. There’s a right size to be, and I think being the right size is extremely important. For some kinds of trades, the bigger the better, for other kinds of trades, the smaller the better.

In a hedge fund you have the luxury of hiring full-time people to keep track of things, you can hire teams of people to do data scrubbing, and you can buy a lot more data and research.

On the other hand, you’ve got more overhead. People say hedge funds are unregulated, but you wouldn’t know it when you see the masses of paper they churn out every month. So, in a lot of ways, it’s easier to be a standalone trader where your expenses are just your monthly bills. You don’t have any employees to worry about, you don’t have as much compliance concerns, you don’t have to worry about investors. With hedge funds, you’ve always got to think about keeping your investors happy.

Penn: Sure.

Brown: You’ve got to be liquid enough to fund withdrawals and accommodate additions. And there are a lot of things about running the business that it’s nice to be without .

Penn: Sure.

Brown: People can be envious, figuring that hedge funds are connected and know everything-it must be so easy for them. Sometimes, in a hedge fund, you feel like, “Boy, I’d like to just trade by myself again and not have to worry about all this paperwork and all the staff.”

I think most people who run hedge funds would be trading for themselves if they didn’t have the fund. And a lot of people switch back and forth between trading for themselves and running a fund

I would say, roughly speaking, you can double or triple your scale becoming a hedge fund. But you have to put up with a certain amount of organizational stuff to do it. If you like being with people, you like being in an office, you like kind of having a network of people to support you, then a hedge fund is better. But if you like being completely independent and not having to deal with people at all, trading for yourself is a very attractive way to make a living.

Penn: Asking a little bit more about the hedge funds, to sort of wrap things up, if you’re going to characterize the fund in terms of what it does, you mentioned it’s a quant fund. In terms of the markets that it participates in, is that pretty much wide open?

Brown: I can’t talk about our hedge fund in particular, but yeah, basically quant hedge funds will go anywhere. People think of them as equity, U.S. equity funds. Because that’s the most liquid market.

For a quant strategy, you need to have a backtest. That means you need to trade something liquid enough so you can get a price series for it. As long as there’s a price series, and something is liquid, then you’ll find quants are in there, and quants are doing quite well.

Penn: OK.

Brown: Then there’s the stuff that isn’t like that, where you can’t get a price series, where it’s kind of one-of-a-kind-things like private equity, real estate, a lot of physical investments. Quants haven’t broken into that space yet.

Penn: What sort of changes do you see happening either in hedge funds in general or with quant funds, in specific, going forward? Will they be moving into these
other areas?

Brown: We’re at an uncomfortable point in the hedge fund evolution. You know, we’ve got these funds with between $10 and $100 billion. And that makes economic sense to me. Over $100 billion you’re an asset management company. You may run a few hedge funds in there, but you’re in the asset management business. You’re on every institution’s, ever pension fund’s list, you’ve got public investments, you’ve got regulators in there, and so on. You’ve got a lot of
employees who aren’t necessarily risk takers or traders, or people who want to work nine to five with job security — you’re a big company, a lot of responsibilities.

And that’s a perfectly good business model, you know. And that’s a great business to be in. But you’re no longer a hedge fund.

Or you’re under $10 billion and basically you’ve got your investors, you’re not looking for new ones, you’re turning people away, and you’re only accepting investors if you think they won’t be any trouble. If they see things your way, and they understand the conditions under which you’ll make or lose money for them. That’s another great business to be in, but you can’t get too big.

Hedge funds in between can pose systemic risks. They’re big enough to attract the attention of regulators. But they’re not regulated. They’re still close enough to
their hedge fund roots that they may have this attitude, “We do what we want, and we want investors who like it. When an investor pulls out, we didn’t want them anyway. It’s good for both of us to let them go.” I think that space is going to clear out.

I think there will be a revolution in asset management in general. I think we’ve got some big, lazy asset management companies out there and I think they’re going to get a surprise at some of these upstarts, that started as hedge funds. And I think other hedge funds are going to shrink. They’re going to say, “OK, we got too big, we more investors than we need, people who didn’t understand us, so we’re going to shrink in terms of staff, in terms of assets under management, and we’ll be more idiosyncratic and pursue smaller capacity strategies.”

And I think that’ll make the regulators happy. You know, they will no longer worry about totally a unregulated hedge fund getting big enough to cause a huge
problem.

Penn: Sure. It sounds almost like a win-win situation all around, if they go that route.

Brown: Yeah, it’s a sensible thing. I usually predict the sensible thing and often people do stupid things instead. I could be wrong about how things will evolve.

Penn: One last question. Thinking about the path that someone would take, a young person starting out, on the road to becoming a financial engineer. As someone on Wall Street who sees the people arrive, what does it take? And not take?

Brown: I see an awful lot of people like that, and I’m worried about them. Why would someone want to be a financial engineer? Finance is a great profession, so is engineering, but they take different kinds of people. I think you need to want finance first, then decide to use your quant skills to get in via the financial engineering route.

We get these people who studied physics or math, and they say, “Gee, I can’t get a job in that, or I’m bored with that, so I’ll go into finance. It seems to pay well and there are a lot of recruiters for banks around.” These people don’t have a risk taking in their souls. They really want a nine-to-five job where they’ll never be wrong, they’ll always be told how smart they are. They won’t have to deal with being proven wrong 45% of the time if they’re good-if they’re great. And they’re not going to be happy in a field that doesn’t care if you can explain why your losing trade was really right or why the other guy’s winning trade was really wrong, that doesn’t care how smart or clever you are or how many degrees you have, that only cares about the next trade.

Finance remains a field that should be restricted to risk takers. I’m talking about investing. I mean, we’ve got room for salespeople, we’ve got room for investment bankers and stuff like that. If you like that kind of stuff you can go do that. But if you’ve got a good brain, you should use it for something good. And finance isn’t it, unless you really like the risk. Risk should make you happy. You probably will make a lot of money because it’s pretty easy to make money in finance, but you know, the important thing is will you be happy doing it. And we’ve burned out a lot of people at Wall Street.

Penn: That’s something.

Brown: We’ve hire tons of these quants, work them to death, and then a lot of them are out of a job after four or five years and nothing really to show for it. They made a lot of money when they were here, but had no real career. So you know, you really look at yourself and say, “Am I a poker player? Am I somebody who takes risks? Am I somebody who likes to play the game for myself, or am I somebody who wants to study? Would I rather be right 55 times and wrong 45, or be right once and never wrong but make only one-tenth the money?” And if you’re the second kind of person, there are lots of great things to do in the world. You shouldn’t be wasting yourself in finance.

Penn: Interesting observation. Larry Connors, our CEO, talked with Emanuel Derman about some of these issues, of the road to being a financial engineer, for
example. And you’re making some interesting points that he didn’t quite touch on, or at least not in the same way.

Brown: Emanuel is a friend of mine, by the way, and that’s a great program he runs. One of the things about his program is he gets practitioners in there, and if you go through that program you know what finance is like.

Another good program in that respect is the Haas program at Berkeley, they have a lot of the top academic practitioners. But boy, in some of these programs, you get taught by people trained in physics, and they learned some financial math from people who never were on Wall Street. So you come out and yes, you get a job, but boy, you’re not prepared for the job and you don’t know if you’ll ever be happy doing it. And it’s just not right. Really, I would much rather get somebody who’s a risk taker, who has to struggle a little in the math, than somebody who knows the math cold but doesn’t like risk.

Penn: Do you think that Wall Street or the hedge fund industry has reached a little bit of an exhaustion point? Has there been a bit of a run on the quants without stopping to say, “Wait a minute, are we checking some of the things that you are talking about checking, and some of the things that Emanuel Derman is doing to make sure you’re getting the right types of people involved?” Is it still a gold rush thing where anybody with the right letters after his name gets scooped up?

Brown: It’s absolutely a gold rush. And you don’t even need the letters. As long as you’ve got good math skills and you’re willing to work really hard, they want you and they’ll throw you at stuff. And if you make money great, and if you don’t make money you’re out. Usually there’s somebody younger and cheaper in a few years, so unless you really are going somewhere in finance, you know.

If somebody comes along and says they want to trade, they want to be a portfolio manager, they want to come up with new strategies, I’d say great-but I’m not going to start you on that, you’ve got to learn this other stuff. Somebody comes to me and says, “I want to be a risk manager in my life, I want to refine models for traders, I want to program complex algorithms,” I say, “Go work for a software company, go work for somebody who values that kind of stuff, because we don’t.”

You always want to be in a business where your kind of people are running the place.


More information about Aaron Brown and his book, The Poker Face of Wall Street, can be found on his website at www.eraider.com
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